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Security Analysis and Portfolio Management

The document discusses the Capital Asset Pricing Model (CAPM) and its key assumptions and principles. It states that CAPM posits that only systematic risk, as measured by beta, is priced, while unsystematic risk can be diversified away. It notes that while initial empirical tests supported CAPM, more recent studies have cast doubt on beta being the sole determinant of risk and price. The document also discusses the theoretical conditions under which CAPM is valid or invalid.

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Saptarshi Ray
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© Attribution Non-Commercial (BY-NC)
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Download as PPT, PDF, TXT or read online on Scribd
33 views

Security Analysis and Portfolio Management

The document discusses the Capital Asset Pricing Model (CAPM) and its key assumptions and principles. It states that CAPM posits that only systematic risk, as measured by beta, is priced, while unsystematic risk can be diversified away. It notes that while initial empirical tests supported CAPM, more recent studies have cast doubt on beta being the sole determinant of risk and price. The document also discusses the theoretical conditions under which CAPM is valid or invalid.

Uploaded by

Saptarshi Ray
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Security Analysis and

Portfolio Management

Equilibrium Asset Pricing Models:


Capital Asset Pricing Model
Arbitrage Pricing Theory
Pricing of Risky Assets
• What attribute is priced at the
market place?
• How is that attribute translated
into market price?

2
Capital Asset Pricing Model
Assumptions:
 Investors can choose between portfolios
on the basis of expected return and
variance
 All investors are in agreement as to
investment horizon of one time period
and the distribution of security returns
 No friction in the capital market –
financially or informationally
3
Capital Asset Pricing Model
 Answer to the question as to how risky
assets are priced in the market place
with respect to their risks if investors
make their investment choices based on
portfolio theory
 Beta – the slope of characteristic line -
is the standard measure of risk
 Prediction is rather simple: Market
4 Portfolio is efficient
Attributes of Market Portfolio
 Portfolio of all risky assets
 Not without risk, but that is only
systematic risk – unsystematic risk is
eliminated
 Risk of an individual asset is measured by
its contribution to riskiness of market
portfolio
 Variance of returns of an asset is the
aggregate of variation explained by the
5 market and the residual error– the latter is
not priced
Risk of an individual asset
 2 (rj )   j  2 (rM )   2 ( j )
2

 2 ( j )is diversifiable and therefore, is not priced.


Riskyness of an asset is its contribution to portfolio risk.
Cov(rj , rM )
Portfolio risk is simply weighted average of covariances with individual assets.
M
 (rM )  Cov(rM , rM )   x j Cov(rj , rM )
2

j 1
M
Cov(rM , rM )
M   x j  j  1
j 1  (rM )
2

6
Position of assets with same βs

7
Position of asset with same ρ
 E (rM )  rF 
E (rJ )  rF    J , M  (rJ )
  (rM ) 

8
Market forces to bring about
equilibrium

9
Theoretical validity
CAPM is valid
 With no risk-free asset

 With a risk-free asset that cannot be

sold
 With lending at risk-free rate, but

borrowing at a higher rate


 With narrow range of transaction costs

10
Validity contd. …..
CAPM is invalid
 If there is disagreement among

investors
 If short-selling is disallowed

 If tax impact on investors differs

 If even a SINGLE investor behaves sub-

optimally
11
Empirical Testing of CAPM
 Early tests produced excellent results but
were flawed; portfolios were diversified
and likely to be on MVF – that would
produce a linear SML even if the market
portfolio is not on MVF
 Need to test MP being on MVF to prove
CAPM validity – MP of all risky assets is
undeterminable
12
Empirical Test contd. …..
 A correlated market proxy may be used;
however, the correlation is usually
unknown
 Individual asset betas have been found
to be unstable – return interval,
portfolio size, transaction volume and
firm size affects beta – and regress
towards mean
13
 CAPM has turned out to be untestable
Summary
 Only market forces determine security
risk and is measured by beta – other
risks are diversifiable and therefore, not
priced
 Initial supporting empirical findings and
convenience of use resulted in
dominance of the model
 Recent empirical findings cast serious
14 doubts on beta being the measure of risk

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